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Leasing Historic Tax Credit Property to Local Governments: Disqualified Lease Rules

By CED Program Interns & Students

Published May 21, 2015


O'Neil Building in Kinston, NCPrevious blog posts have looked at how communities can redevelop historic properties through the creation of public-private partnerships as well as how IRS rules affect the allocation of historic rehabilitation tax credits to investors in redevelopment projects. This blog post explores what happens when properties utilizing federal historic tax credits seek to lease space to local governments and other tax-exempt tenants.

The Case of Emerald City

Tina Woodman, a longtime community member, has approached the city manager of Emerald City, Dora Gale, about possibly redeveloping an historic downtown building. Woodman has a heart for the city and hopes that she can contribute to the downtown’s nascent revitalization through redeveloping the property from an eyesore into a beautiful, productive building. She knows that this will be a challenging project, but believes that with the use of historic rehabilitation tax credit equity and a stable tenant, this project could succeed and, importantly, catalyze further redevelopment. A few years ago she redeveloped another historic building and benefited from both federal and state historic tax credits, which saved her almost 30 percent on the project costs, and made an otherwise infeasible project successful.

Woodman asks Manager Gale if Emerald City would be interested in leasing space in the redeveloped building as municipal offices. It is no secret that the City has outgrown its office space, and its participation would likely improve the project’s ability to attract other investors. Gale is excited about the possibility of moving some of the municipal offices into a building with ties to the city’s storied past. 

What the Internal Revenue Code Says

Section 47 of the Internal Revenue Code (US Code 26) governs rehabilitation credits for development projects. This is the section of the US Code that defines which rehabilitation expenditures qualify for the federal historic rehabilitation tax credit (HTC). The amount of “qualified,” or eligible, expenditures for historic rehabilitation will determine the amount of tax credit equity that a historic rehabilitation project can receive.

However, some historic rehabilitation expenditures are not eligible to receive federal HTCs. When otherwise qualified rehabilitation expenditures are made for a “tax-exempt use property,” the IRS considers the project ineligible for historic tax credits. Expenditures made on buildings that are on tax-exempt use property cannot be considered qualified rehabilitation expenditures. According to an exception provided in Section 47(c)(2)(B)(v)(l) , a property is considered “tax-exempt use” if 50 percent or more of the property is leased to a tax-exempt entity (such as Emerald City) in a “disqualified lease.”

A “disqualified lease,” according to Section 168(h)(1)(B)(ii)(1), is a lease to a tax-exempt entity in which:

  1. Part or all of the property was financed directly or indirectly by an obligation in which the interest is tax-exempt under Internal Revenue Code Section 103(a) and such entity (or related entity) participated in the financing, or
  2. Under the lease there is a fixed or determinable purchase price or an option to buy, or
  3. The lease term is in excess of 20 years, or
  4. The lease occurs after a sale or lease of the property and the lessee used the property before the sale or lease. See Internal Revenue Code Section 168(h)(1)(B)(ii).

If more than 50 percent were leased to a tax-exempt entity in a disqualified lease, according to an exception provided in 26 U.S. Code § 47(c)(2)(B)(v)(I), historic tax credits could only be claimed for the portion of the building that is not rented to a tax-exempt entity.

The Effect on Emerald City and Other Local Governments

Though local governments can be critical partners for developers seeking to rehabilitate historic properties, due to the various regulations within the tax code, public entities should be aware of the implications of their participation in HTC transactions. In addition, private investors and developers of HTC projects should seek assistance from an attorney with experience using HTCs when considering lease options with local governments.

In the case of Emerald City, Dora Gale and Tina Woodman should seek legal advice to avoid surprise or disappointment at the end of the tax credit road.

Andrew Trump is a student in the Master of City and Regional Planning and Master of Public Administration programs at UNC-Chapel Hill. He is also a Fellow with the Development Finance Initiative. This post was prepared in fulfillment of requirements for PUBA 780-004 Community Revitalization Applied (Spring 2015).

Published May 21, 2015 By CED Program Interns & Students

O'Neil Building in Kinston, NCPrevious blog posts have looked at how communities can redevelop historic properties through the creation of public-private partnerships as well as how IRS rules affect the allocation of historic rehabilitation tax credits to investors in redevelopment projects. This blog post explores what happens when properties utilizing federal historic tax credits seek to lease space to local governments and other tax-exempt tenants.

The Case of Emerald City

Tina Woodman, a longtime community member, has approached the city manager of Emerald City, Dora Gale, about possibly redeveloping an historic downtown building. Woodman has a heart for the city and hopes that she can contribute to the downtown’s nascent revitalization through redeveloping the property from an eyesore into a beautiful, productive building. She knows that this will be a challenging project, but believes that with the use of historic rehabilitation tax credit equity and a stable tenant, this project could succeed and, importantly, catalyze further redevelopment. A few years ago she redeveloped another historic building and benefited from both federal and state historic tax credits, which saved her almost 30 percent on the project costs, and made an otherwise infeasible project successful.

Woodman asks Manager Gale if Emerald City would be interested in leasing space in the redeveloped building as municipal offices. It is no secret that the City has outgrown its office space, and its participation would likely improve the project’s ability to attract other investors. Gale is excited about the possibility of moving some of the municipal offices into a building with ties to the city’s storied past. 

What the Internal Revenue Code Says

Section 47 of the Internal Revenue Code (US Code 26) governs rehabilitation credits for development projects. This is the section of the US Code that defines which rehabilitation expenditures qualify for the federal historic rehabilitation tax credit (HTC). The amount of “qualified,” or eligible, expenditures for historic rehabilitation will determine the amount of tax credit equity that a historic rehabilitation project can receive.

However, some historic rehabilitation expenditures are not eligible to receive federal HTCs. When otherwise qualified rehabilitation expenditures are made for a “tax-exempt use property,” the IRS considers the project ineligible for historic tax credits. Expenditures made on buildings that are on tax-exempt use property cannot be considered qualified rehabilitation expenditures. According to an exception provided in Section 47(c)(2)(B)(v)(l) , a property is considered “tax-exempt use” if 50 percent or more of the property is leased to a tax-exempt entity (such as Emerald City) in a “disqualified lease.”

A “disqualified lease,” according to Section 168(h)(1)(B)(ii)(1), is a lease to a tax-exempt entity in which:

  1. Part or all of the property was financed directly or indirectly by an obligation in which the interest is tax-exempt under Internal Revenue Code Section 103(a) and such entity (or related entity) participated in the financing, or
  2. Under the lease there is a fixed or determinable purchase price or an option to buy, or
  3. The lease term is in excess of 20 years, or
  4. The lease occurs after a sale or lease of the property and the lessee used the property before the sale or lease. See Internal Revenue Code Section 168(h)(1)(B)(ii).

If more than 50 percent were leased to a tax-exempt entity in a disqualified lease, according to an exception provided in 26 U.S. Code § 47(c)(2)(B)(v)(I), historic tax credits could only be claimed for the portion of the building that is not rented to a tax-exempt entity.

The Effect on Emerald City and Other Local Governments

Though local governments can be critical partners for developers seeking to rehabilitate historic properties, due to the various regulations within the tax code, public entities should be aware of the implications of their participation in HTC transactions. In addition, private investors and developers of HTC projects should seek assistance from an attorney with experience using HTCs when considering lease options with local governments.

In the case of Emerald City, Dora Gale and Tina Woodman should seek legal advice to avoid surprise or disappointment at the end of the tax credit road.

Andrew Trump is a student in the Master of City and Regional Planning and Master of Public Administration programs at UNC-Chapel Hill. He is also a Fellow with the Development Finance Initiative. This post was prepared in fulfillment of requirements for PUBA 780-004 Community Revitalization Applied (Spring 2015).

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